April 09, 2011

The income tax exemption provided in Section 104(a)(2) of the Internal Revenue Code for "any damages" received "on account of personal physical injuries or physical sickness" specifically excludes "punitive damages".

A separate but related issue: should defendants be able to deduct punitive damages on their tax returns? Right now, they can. The benefit to defendants is obvious. What about plaintiffs? Since the after-tax cost of every dollar paid is lower, should plaintiffs receive more?

Proposals to disallow the deduction have been made multiple times. The Clinton administration proposed it in the 1990s, and the Obama Administration has resurrected the idea. In response, several policy articles have been published debating the merits of allowing defendants to deduct punitive damages, and discussing alternative policies. SK2M asked Jeremy Babener, a 2010-11 NYU Tax Policy Fellow, to explain the tax issues involved and the arguments being made.

Introduction

As part of his 2010, 2011, and 2012 revenue proposals, President Obama proposed to end defendants’ ability to deduct punitive damages.

Currently, punitive damages incurred in connection with a defendant’s business are tax deductible. Consider a plaintiff’s request to a jury for $1 million in punitive damages. If the defendant can deduct the $1 million of damages against $1 million of income taxed at 35%, the true cost of the award to defendant is $650,000. Juries are sometimes informed of the tax consequences of damages, and sometimes not.

The Obama Administration argues that the deduction's effect of lowering the true cost to defendants “undermines the role of such damages in discouraging and penalizing certain undesirable actions or activities.”

Polsky and Markel

Gregg Polsky (University of North Carolina School of Law) and Dan Markel (Florida State University College of Law) argue in Taxing Punitive Damages that rather than changing tax law, juries should be informed of the tax consequences of damages. Thus, in the above example, a jury might award plaintiff $1.5 million, knowing that the after-tax cost to defendant would be $1 million. The effect of the Obama proposal, they posit, would likely be circumvented by settlements that allocate less to nondeductible punitive damages, and more to deductible compensatory damages. The IRS may find it difficult to identify and correct such improper settlement allocations.

Zelenak

Lawrence Zelenak (Duke University School of Law), in response to Polsky and Markel, makes two points. First, he suggests that while it might be better to end deductions for punitive portions of damage awards, punitive portions of settlements should remain deductible. Less than five percent of plaintiffs who go to trial are awarded punitive damages. Since it is impossible to identify which settling defendants would have been forced to pay punitive damages, and to determine the amount of such damages, Zelenak argues that punitive damage portions of settlements should be fully deductible.

Second, Zelenak argues that the Polsky and Markel solution ignores the deterrence role of punitive damages. In part, punitive damages are supposed to force a defendant to pay for the costs to injured parties who could not or would not bring legal action. If those injured parties had sued, the defendant would have been able to deduct the resulting compensatory damages. From a deterrence point of view, therefore, the defendant should be able to deduct the punitive damages paid to plaintiff that substitute for deductible compensatory damages. Zelenak writes that Polsky and Markel focused only on the punishment rationale for punitive damages, which suggests that a reduction in the true cost of punitive damages, via deductibility, reduces defendants' intended punishment. Of course, as Zelenak concludes, balancing the punishment and deterrence rationales of punitive damages is very difficult.

Mogin

Paul Mogin (Williams & Connolly, LLP), also in response to Polsky and Markel, argues three separate points. First, many courts prevent defendants from encouraging reductions in damage awards by either informing juries when plaintiffs will receive damages tax-free, or by introducing evidence of a plaintiff’s previous reimbursement for economic losses. Therefore, Mogin writes, allowing plaintiff to introduce defendant’s ability to deduct punitive damages would create a “pro-plaintiff imbalance.”

Second, Mogin asserts that providing juries with additional encouragement to increase punitive damages would exacerbate juries’ already distorted pro-plaintiff perception of corporate defendants. While evidence of a defendant’s wealth is generally inadmissible in court, the rule does not typically hold for punitive damages. The U.S. Supreme Court has recognized that the presentation of a defendant’s wealth “creates the potential that juries will use their verdicts to express biases against big business.” Thus, Mogin argues, juries should not be further encouraged to increase punitive damages awards.

Third, Mogin criticizes Polsky and Markel for elevating the jury’s assessment of punitive damages above its rightful place. Historically, judges have reduced or set aside unduly harsh punitive damages. Moreover, while the jury’s role is one of fact-finder, the measure of punitive damages is hardly factual. Why then should it be so important that the true cost of defendant’s damages are exactly equal to the amount the jury intended?

There's Always More

Several other papers have been written on disallowing defendant deductions for punitive damages, including a 2010 article published by the Heritage Foundation, and a 2001 report by the New York State Bar Association.

Jeremy Babener's articles on the taxation of personal injury damages and structured settlements are available at TaxStructuring.Com. Babener is a 2010-11 NYU Tax Policy Fellow. Having worked for the U.S. Department of the Treasury's Office of Tax Policy in the Fall of 2010, he will graduate from NYU School of Law's Graduate Tax Program this Spring.

Featuring industry leaders, commentators and professional association conferences, S2KM has attempted to highlight how legal and technology changes are redefining the traditional (pre-2001) structured settlement market including structured settlement public policy as well as structured settlement business standards, business practices and business models.

From S2KM's perspective, the following categories, people and developments defined the structured settlement and special needs settlement planning industries in 2010:

As a general observation, all of these conferences were valuable and complementary. For S2KM's 2010 (plus historical) conference reports, see S2KM's structured settlement wiki.

SSP, NASP and NAMSAP deserve special recognition for their 2010 strategic educational discussions featuring industry leaders, commentators and critics who offered alternative perspectives for improving and growing the structured settlement and special needs settlement planning markets.

By comparison, NSSTA remains reluctant to openly discuss strategic industry issues or to include alternative perspectives in their educational programs. More positively, NSSTA representatives and members increasingly attend and speak at non-NSSTA structured settlement and special needs settlement planning conferences.

NAELA's educational conferences are noteworthy because they regularly feature sections or entire programs titled "unprograms". NAELA's unprograms are moderated group discussions about specific topics. NAELA's 2010 Special Needs Summit included six separate one hour unprograms with a concluding unprogram wrap-up session. One example of a 2010 NAELA unprogram was titled "Collaboration Opportunities for Special Needs Attorneys and Financial Planners".

Industry leaders

NSSTA promoted Eric Vaughn, who previously served as NSSTA's lobbyist, to replace Joseph Ricci as NSSTA's new Executive Director effective July 1, 2010. Peter Arnold, previously NSSTA's Marketing Director, was similarly promoted to serve as NSSTA's Associate Executive Director. NSSTA's Board of Directors elected Michael Kelly as its 2010 President and Dan Finn as its President-elect. NSSTA honored Congressman Peter Stark during its Annual Meeting as its 2010 Legislator of the Year. NSSTA also gave special recognition to Karen Meyers and Joseph Bornstein for their contributions to NSSTA's CSSC and NSSTAPAC programs respectively..

SSP elected Jason Lazarus as its President for 2010-11 and Charles Schell as Vice President. SSP honored Richard Risk with the designation of "life member" for his contributions to SSP and the settlement planning industry. Joseph Tombs continues as Director of SSP's RSP certification program.

NASP named Matthew Bracy as its new President succeeding Robin Shapiro. Earl Nesbitt continues as NASP's Executive Director.

NAMSAP elected Michael Westcott as its President.

NAELA honored Dick Traum as the first recipient of NAELA's Special Needs Leadership Award. Traum is the founder and CEO of Achilles International, a non-profit organization providing community support for athletes with disabilities with members in more than 70 countries.

Amy Palmiero-Winters, ultra-marathoner and lower-leg amputee, was named during 2010 as the winner of the 2009 James E. Sullivan Award given annually to the top amateur athlete in the United States.

Industry commentators

For the past several years, Robert Wood has been the preeminent tax commentator and author for the structured settlement and settlement planning industries. Wood's publications appear on the Wood & Porter website.

During 2010, Jeremy Babener emerged as an important new structured settlement tax commentator and author specializing in public policy and proposing an expanded structured settlement tax subsidy. In addition to authoring several structured settlement articles for tax and legal journals, Babener participated as a featured speaker at both the SSP and NASP 2010 Annual Meetings and authored two blog posts for S2KM during 2010. Babener discussed his structured settlement writing (accessible on S2KM's structured settlement public policy wiki and Babener's Tax Structuring website) in this 2010 S2KM interview.

An increasing number of structured settlement and special needs settlement planning professionals published blogs during 2010 joining industry blogging pioneers such as John Darer, Mark Wahlstrom, Matthew Bracy and Jack Meligan.

Incisive Media published two new updates (Release 47 and Release 48) for "Structured Settlements and Periodic Payment Judgments" during 2010.

Dodd-Frank re-writes federal banking law and creates a new Bureau of Consumer Financial Protection. A key question, as yet unanswered, is whether the sale and/or purchase of structured settlement annuities constitutes a "financial product or service" under Dodd-Frank requiring regulatory supervision by the Bureau.

Regulations

The United States Department of Treasury held a public hearing on February 23, 2010 focused on proposed new regulations for Internal Revenue Code section 104(a)(2). The proposed regulations, if enacted, would:

Eliminate the requirement that damages be based on “tort or tort type rights” in order to qualify for the section 104(a)(2) tax exclusion, and

Incorporate 1996 legislation requiring that personal injuries and sickness damages be “physical” in order to qualify for the section 104(a)(2) tax exclusion.

A subsequent S2KM interview featured John McCullough and Richard Risk, two of the structured settlement industry members who spoke at the hearing.

The Centers for Medicare and Medicaid Services (CMS) continued to issue administrative guidance during 2010 for enforcement of the Medicare Secondary Payer (MSP) Act of 1980 and the Medicare, Medicaid and SCHIP Extension Act of 2007 (MMSEA) reporting requirements for insurers. Featured discussions during the NAMSAP 2010 Annual meeting highlighted:

The increasing importance and complexity of the MSP statute for all personal injury stakeholders;

The need for these personal injury stakeholders (and their professional associations) to cooperate politically and educationally;

The evolving business models, claim management strategies and professional skill sets which are now emerging to address these challenges.

Case law

The Spencer v. Hartford class action lawsuit which settled in 2010 represents one of the most important legal developments in the history of the structured settlement industry.

Hartford's gross settlement payment of $72.5 million represents 4.5% of total premium dollars Hartford used to purchase structured settlement annuities for class members from January 1, 1997 to June 7, 2010.

Among the plaintiffs allegations:

Hartford and its attorneys, brokers and agents violated the Racketeer Influenced and Corrupt Organizations Act (RICO) and committed common law fraud in structuring its settlements.

Hartford's structured settlements were priced so Hartford retained 15% of the value of the structured settlements.

Hartford and its attorneys, brokers and agents misrepresented structured settlements including explicit or implicit reference to:

The "cost" of the annuity or structured settlement or portion of the settlement being structured; and/or

The "value" of the annuity or structured settlement or portion of the settlement being structured.

Hartford, which stopped writing new structured settlement business in 2009, denied the allegations.

Technology

Despite the accelerating technology advances revolutionizing society generally, the structured settlement and special needs settlement planning industries have been slow to study and incorporate these advances into their educational programs and business models.

The best industry-sponsored technology education programs during 2010 were offered by Mark Miller during a NAELA webinar and Harry Margolis at the ASNP 2010 Annual Meeting. Both presentations provided introductory overviews of web 2.0 and including recommendations for integrating specific social networking tools into special needs legal practices.

NSSTA initiated a NSSTA blog during 2010 and offered an educational program about Internet marketing during its 2010 Fall Education program.

Public policy

Both SSP and NASP featured specific discussions and presentations about structured settlement public policy during their 2010 Annual Meetings. The discussions included industry commentators representing diverse viewpoints and priorities.

In a 2010 Boston College Law Review article, professors Gregg Polsky and Brant Hellwig challenged the application of any structured settlement tax benefit for deferring attorney fees or payments to non-physically injured tort plaintiffs under general common law tax principles.

Business standards and practices

The Spencer v. Hartford case raises many issues about structured settlement business standards and practices which require greater education and analysis if the primary market expects to improve and grow. For example;

Is the primary structured settlement market capable of self-regulation?

As an additional requirement, or as an alternative, why haven't plaintiff attorneys and plaintiff consultants insisted upon a claimant's written informed consent before entering into a structured settlement?

"Cash now" advertising represents one of the most highly criticized secondary market business practices. Although this practice continues to exist, NASP took an important educational step during its 2010 Annual Meeting by highlighting this issue and inviting secondary market critics to participate in the discussion.

Business models

While other segments of, and products within, the special needs settlement planning market have expanded and improved in recent years, the structured settlement primary market in general has stagnated and retrenched.

During 2010, however, representatives of the primary structured settlement market increasingly recognized their interdependency, and interacted, with other settlement planning professionals and professional associations such as special needs attorneys, life care planners, Medicare set-aside professionals and secondary structured settlement market participants.

Future industry improvement and growth will require even greater appreciation and identification of shared interests as well as expanded implementation of shared political strategies, educational programs and business models.

May 12, 2010

Tax laws and tax policy are critically important for structured
settlements. Based upon interviews he conducted with structured
settlement industry leaders, Jeremy Babener states in his recently published article about "Structured
Settlements and Single-Claimant Qualified Settlement Funds":

"It
seems roundly agreed that the ......structured settlement market owes
its existence almost entirely to the tax subsidy."

The most positive tax information was the declaration of support
for structured settlements during the NSSTA meeting by key
Congressmen including Max Baucus, Chairman of the Senate Finance
Committee; Sander Levin, Chairman of the House Ways and Means
Committee; and David Camp, ranking Republican on the House Ways
and Means Committee.

Congressman Camp provided the most concise tax-oriented legislative
endorsement of structured settlements. Camp stated: "With
tax reform, everything is on the table. But structured settlements are
not on the table. Congress has a long history of support for structured
settlements on a bi-partisan basis. Don't expect much debate over
structured settlements."

The new tax ideas for growing the structured settlement market
were highlighted by Babener in his precursorpresentation
to the SSP tax panel titled: "Justifying and Expanding the Structured
Settlement Tax Subsidy". Among Babener's ideas for improving and growing
the structured settlement market, he recommends changing the
current tax subsidy into a tax credit. According to Babener,
who outlines his proposal in an article published in Tax
Notes titled "Expanding the Structured Settlement Tax Exclusion",
the current tax subsidy provides no benefit for structured settlement
recipients unless they pay taxes - which many of whom do not. Babener's
article is available on his Tax Structuring website.

Both the SSP and NSSTA 2010 tax panels featured Michael Montemurro,
Branch Chief, Office of Associate General Counsel of the IRS. SSP has featured Montemurro on two prior tax
panels.

By contrast with NSSTA, SSP allotted more than two hours
(compared with NSSTA's one hour) for its tax panel. In addition, SSP
offered Babener's introductory public policy discussion plus 40 minutes
of follow-up discussion. The added time allowed SSP to incorporate
Michael Montemurro into a broader discussion which included practical
advice (Dan Hindert discussing 468B QSFs), criticism of current tax laws
(Professors Gregg Polsky and Brant Hellwig attacking tax deferrals
for non-physical injuries and plaintiff attorneys fees) plus extended
public policy discussions including secondary market issues.

Both SSP and NSSTA deserve congratulations for their 2010
structured settlement tax panels. SSP's tax panel (organized and
moderated by Richard Risk) has become the new industry standard -
surpassing what NSSTA formerly and regularly featured as its "Tax
Posse". NSSTA's 2010 tax panel (organized and moderated by
Michael Miller) re-established NSSTA as an important educational
resource for structured settlement tax issues.

Gregg Polsky - Law professor formerly at
Florida State University and now teaching at the University of
North Carolina. Co-author with Brant Hellwig of a 2010 law review
article titled "Taxing Structured Settlements" published in the
January 2010 edition of the Boston College Law Review.

Jeremy Babener - author during 2010 of several
public policy articles about structured settlements. Babener's articles
are available on his website Tax Structuring. S2KM's reviews of Babener's writing
and interviews with Babener are featured on S2KM's structured settlement public policy wiki. In
addition to participating on the SSP tax panel, Babener spoke separately
at the SSP meeting about "Justifying and Expanding the Structured
Settlement Tax Subsidy".

NSSTA's tax panel

Michael Miller as organizer and moderator. Former co-chairman of NSSTA's legal committee. Also summarized the Spencer
v. Hartford settlement at the NSSTA meeting.

Michael Montemurro -
Branch Chief, Office of Associate General Counsel of the IRS.

Kirk
Van Brunt - a member of the NSSTA legal committee and a structured
settlement taxation subject matter expert.